Sunday, May 29, 2011

What's in a Stock?

So you were convinced enough by my earlier post on why stocks to put some money in?  But you don't know what to look for in a stock?  Especially in bear markets when the economy is going down and stocks as a whole drop in price, it is important to pick good stocks.  In bull markets, it is still important but a little less so since generally stocks as a whole will go up.

There are several features that you should pay attention to when picking a stock.  These include the P/E (price over earnings) ratio, market capitalization, and return on equity.

You always want to be on the lookout for stocks that are undervalued, or priced below what they are worth.  The difficult thing is to determine the true value of a company.  The P/E ratio can give some indication about what investors think about the value of the company and it is a good indicator when compared to the average P/E for the companies in the same industry.  To get the P/E ratio, you simply take the price of the stock and divide it by the earnings per share (EPS) for that company.  I generally look for P/E ratios between 10 and 20 for a stock.

Why not look for P/E ratios as small as possible?  While you don't want to buy stock from a company with an extremely high P/E (suggesting that it is way overpriced), you also don't want very low P/E ratios because that means that investors don't expect much in terms of future earnings.  You also want to compare the P/E ratio with the average of that industry.  Technology companies generally have higher P/E ratios as a whole than say consumer products because investors expect much higher growth.  To see if a company is over or undervalued, you should compare its P/E with its industry average.

The market capitalization is the total dollar market value of all of a company's shares of stock.  This is used to determine a company's size.  Generally, companies are referred to as large-cap, mid-cap, or small-cap to denote the different groupings in terms of market capitalization.  Large-cap stocks are usually above $10 billion, mid-cap between $2 billion and $10 billion, and small cap at less than $2 billion.  Large cap stocks are usually the most well known companies like Bank of America, Exxon Mobil, IBM, and Walmart.  They are usually more stable than other cap sizes.  Small-cap, on the other hand, tend to be more volatile but exhibit more growth over the long-run.  Stocks with the same market capitalization also generally see similar performance so it would be good to diversify your investments among the different market capitalizations.

Finally, another big number to look for is the ROE (return on equity) of a stock.  The return on equity is calculated by dividing net income by shareholder's equity.  What this final number represents is the corporation's profitability by showing how much income the company generates with the money shareholders have generated.  You want to look for a higher ROE and companies with an increasing ROE.

Of course, there are many other factors to look at before making your final decision to invest in a company.  These are just starting points when you want to evaluate whether a company has potential or not.  These are also fundamental traits which look at the specific characteristics of a company.  You may also want to include some technical analysis to help decide when is a good time to buy a stock, but I will go over that in a later post.  I would also strongly recommend that college-aged students begin investing with a fake portfolio and I will discuss some good sites where you can practice and see how you do over a few years in college before you start investing part of your income every month.

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